THEFINANCINGDECISION
Youcanhavetoomuchdebt…ortoolittle..
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DebtRatiosacrossCompanies
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DebtRatiosacrossSectors
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TheFinancialBalanceSheet
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Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible
Residual Claim on cash flowsSignificant Role in managementPerpetual Lives
Growth Assets
Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and
short-lived(working capital) assets
Expected Value that will be created by future investments
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TheBigPicture..
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The Investment DecisionInvest in assets that earn a
return greater than the minimum acceptable hurdle
rate
The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to
fund your operations
The Dividend DecisionIf you cannot find investments
that make your minimum acceptable rate, return the cash
to owners of your business
The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used
to fund it.
The return should reflect the magnitude and the timing of the
cashflows as welll as all side effects.
The optimal mix of debt and equity
maximizes firm value
The right kind of debt
matches the tenor of your
assets
How much cash you can
return depends upon
current & potential
investment opportunities
How you choose to return cash to the owners will
depend on whether they
prefer dividends or buybacks
Maximize the value of the business (firm)
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Disney’sDebtLoad
¨ Attheendof2013,Disneyhad$15.96billionindebtoutstanding.¤ $13billioninconventionalinterestbearingdebt(withabookvalueof$14.3billion
¤ $2.96billioninoperatingleasedebt(withnodebtequivalentshownonthebalancesheet)
¨ Asapercentofitsmarketvalueasacompany,debtwas11.4%ofitsvalue.Asapercentofbookvalue,debtwas40%ofvalue.
¨ AsamultipleofEBITDA,debtwas1.3timesEBITDA.
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Tesla:DebtLoadovertime
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1.Definedebtbroadly
¨ GeneralRule:Debtgenerallyhasthefollowingcharacteristics:¤ Commitmenttomakefixedpaymentsinthefuture¤ Thefixedpaymentsaretaxdeductible¤ Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrolofthefirmtothepartytowhompaymentsaredue.
¨ Asaconsequence,debtshouldinclude¤ Anyinterest-bearingliability,whethershorttermorlongterm.
¤ Anyleaseobligation,whetheroperatingorcapital.
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OperatingLeasesatDisney
¨ The“debtvalue” ofoperatingleasesisthepresentvalueoftheleasepayments,ataratethatreflectstheirrisk,usuallythepre-taxcostofdebt.
¨ Thepre-taxcostofdebtatDisneyis3.75%.
¨ DebtoutstandingatDisney=$13,028+$2,933=$15,961million
Disney reported $1,784 million in commitments after year 5. Given that their average commitment over the first 5 years, we assumed 5 years @ $356.8 million each.
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Year Commitment Present Value @3.75% 1 $507.00 $488.67 2 $422.00 $392.05 3 $342.00 $306.24 4 $272.00 $234.76 5 $217.00 $180.52
6-10 $356.80 $1,330.69 Debt value of leases $2,932.93
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2.Thedebtdecisionisdrivenbyarealtradeoff
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Implication1:TheMarginalTaxRatematters
¨ Thetaxbenefitofdebtisdirectlylinkedtonotonlywhetheryouareallowedtodeductinterestexpensesfortaxpurposes,butalsoyourmarginaltaxrateonincome.¤ Ifinteresttaxdeductionsarelimited,companieswillborrowlessmoney.
¤ Asthemarginaltaxraterises(falls),companieswillborrowmore(less)money.
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Implication2:ExpectedBankruptcyCostsmatter
¨ Companieswillborrowlessmoney,ifexpectedbankruptcycostsrise.
¨ Expectedbankruptcycostsareafunctionof¤ Volatilityinearnings:Asearningsbecomelesspredicable,borrowingswillincrease
¤ Bankruptcylaws:Asbankruptcylawsbecomemore(less)lenient,companieswillborrowmore(less)
¨ Ifthegovernmentoperatesasabankrupt,bailingoutentitiesthatborrowtoomuch,everyentitywillborrowmore.
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Implication3:Thewiderthechasmbetweenlenders&equityinvestors..
¨ Agencycostsarisebecausewhatequityinvestorswantfromabusinessisverydifferentfromwhatlenderswantfromthebusiness.
¨ Whenlendingmoney,sensiblelendersincorporatethisrealityintowhethertheylend,howmuchtheylend,theinterestratestheychargeandthecovenantsthattheywriteintoloans.
¨ Themoredifficultitistomonitorwhatborrowersaredoingwiththelentmoney,thegreatertheagencycostsandthelesslendingtherewillbe.
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TheTradeoffforDisney
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¨ TaxBenefits:TheUShasthehighestmarginaltaxrateintheworld.Disney,sinceitmakesmoney,shouldbenefitfromusingdebt.
¨ AddedDiscipline:ThereisaseparationofownershipandmanagementatDisney,shouldleadtomoredebt.
¨ ExpectedBankruptcycosts:Disneyislargeandspreadovermultipleentertainmentbusinesses,withacashcowinESPN.Shouldleadtomoredebt.
¨ AgencyCosts:Disneyhasassetsthatarephysicalandtangible(themeparks)againstwhichitshouldbeabletoborrowmoney.
Bottomline:Disneyshouldborrowasubstantialamount.
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TheDebtTradeoffforTesla
¨ Notaxbenefits:Itisacompanythatis notonlystilllosingmoneybuthascarriedforwardlossesofcloseto$4.3billion,effectivelynullifyinganytaxbenefitsfromdebtforthenearfuture.
¨ Nodisciplinaryfunction:WithElonMusk,thelargeststockholderatthecompany,atthehelm,thereis nobasisfortheargumentthatdebtwillmakemanagersmoredisciplinedintheirinvestmentdecisions.
¨ Largebankruptcyrisk:Thecompanyisstillyoungandlosingmoney,and addingacontractualcommitmenttomakeinterestpaymentsontopofalloftheothercapitalneedsthatthecompanyhas,strikesmeasimprudent,withthepossibilitythatonebadyearcoulditspromiseatrisk.
¨ Agencyproblems:InacompanylikeTesla,makinglargeandriskybetsinnewbusinesses, thechasmbetweenlendersandequityinvestorsiswide,andlenderswilleitherimposerestrictionsonthecompanyorpriceintheirfears(ashigherinterestrates).
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3.Butmanydebtchoicesaredrivenbyillusorytradeoffs
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Orbyothermotives..
¨ Lackofaccesstoequity:Insomecases,companieshavetoborrowmoneybecausetheycannotraiseequity,eitherbecausetheyareprivatebusinessesorbecauseequitymarketsareundeveloped.
¨ Control:Inothercases,companiesthatshouldbeusingequityusedebtinsteadbecausethecompanyiscloselyheldandthecontrollingequityinterestsdon’twanttoriskgivingupcontrol.
¨ Subsidies:Sometimes,lenderslendat”subsidized”ratesandequityinvestorstakeadvantageofthosesubsidies.
WhichonedoyouthinkbestexplainsTesla?
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4.Themixofdebtandequitydrivesyourcostofcapital,andhenceyourvalue
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Andchangingthatmixwillchangeyourcostofcapital
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Hereisanexample:Disneyin2013
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Herearethe“firmspecific”determinants
¨ Marginaltaxrate:Holdingallelseconstant,loweringthetaxratewilllowertheoptimal.Atazeropercenttaxrate,Disney’soptimaldebtratiobecomeszero.
¨ CashFlowGeneration:Holdingallelseconstant,themorecashflowthatafirmgenerates,relativetoitsenterprisevalue,themoreitcanborrow.Disney’sEBITDAwas9.35%ofitsenterprisevaluein2013.
¨ VolatilityinCashflows:Holdingallelseconstant,themorevolatilecashflowsare,thelessacompanyshouldborrow.
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Andhereistheonlymacrodeterminant:Therelativepricesofriskinequity&debtmarkets
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ERP/Baa Spread Baa - T.Bond Rate ERP
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5.Andthepathwaytoyouroptimaldebtratiodependson..
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > OptimalOverlevered
Actual < OptimalUnderlevered
Is the firm under bankruptcy threat? Is the firm a takeover target?
Yes No
Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withnew equity or with retainedearnings.
No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.
Yes No
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withdebt.
No
Do your stockholders likedividends?
YesPay Dividends No
Buy back stock
Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.
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AppliedtoDisney(in2013)
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > OptimalOverlevered
Actual < OptimalActual (11.58%) < Optimal (40%)
Is the firm under bankruptcy threat? Is the firm a takeover target?
Yes No
Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
YesTake good projects withnew equity or with retainedearnings.
No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.
Yes No. Large mkt cap & positive Jensen’s a
Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital
Yes. ROC > Cost of capitalTake good projectsWith debt.
No
Do your stockholders likedividends?
YesPay Dividends No
Buy back stock
Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.
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6.Therightdebtforyourfirmwilllooklikeequity
¨ Theobjectiveindesigningdebtistomakethecashflowsondebtmatchupascloselyaspossiblewiththecashflowsthatthefirmmakesonitsassets.
¨ Bydoingso,wereduceourriskofdefault,increasedebtcapacityandincreasefirmvalue.
Firm Value
Value of Debt
Firm Value
Value of Debt
Unmatched DebtMatched Debt
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DesigningDebt:Bringingitalltogether
Duration Currency Effect of InflationUncertainty about Future
Growth Patterns Cyclicality &Other Effects
Define DebtCharacteristicsDuration/Maturity
CurrencyMix
Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future
Straight versusConvertible- Convertible ifcash flows low now but highexp. growth
Special Featureson Debt- Options to make cash flows on debt match cash flows on assets
Start with the Cash Flowson Assets/Projects
Overlay taxpreferencesDeductibility of cash flowsfor tax purposes
Differences in tax ratesacross different locales
Consider ratings agency& analyst concernsAnalyst Concerns- Effect on EPS- Value relative to comparables
Ratings Agency- Effect on Ratios- Ratios relative to comparables
Regulatory Concerns- Measures used
Factor in agencyconflicts between stockand bond holders
Observability of Cash Flowsby Lenders- Less observable cash flows lead to more conflicts
Type of Assets financed- Tangible and liquid assets create less agency problems
Existing Debt covenants- Restrictions on Financing
Consider Information Asymmetries Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt
Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt
If agency problems are substantial, consider issuing convertible bonds
Can securities be designed that can make these different entities happy?
If tax advantages are large enough, you might override results of previous step
Zero Coupons
Operating LeasesMIPsSurplus Notes
ConvertibilesPuttable BondsRating Sensitive
NotesLYONs
Commodity BondsCatastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
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AppliedtoDisney
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Business Project Cash Flow Characteristics Type of Financing
Studio
entertainment
Movie projects are likely to • Be short-term • Have cash outflows primarily in dollars (because Disney makes most of its
movies in the U.S.), but cash inflows could have a substantial foreign currency component (because of overseas revenues)
• Have net cash flows that are heavily driven by whether the movie is a hit, which is often difficult to predict
Debt should be 1. Short-term 2. Mixed currency debt,
reflecting audience make-up.
3. If possible, tied to the success of movies.
Media networks Projects are likely to be 1. Short-term 2. Primarily in dollars, though foreign component is growing, especially for ESPN. 3. Driven by advertising revenues and show success (Nielsen ratings)
Debt should be 1. Short-term 2. Primarily dollar debt 3. If possible, linked to
network ratings Park resorts Projects are likely to be
1. Very long-term 2. Currency will be a function of the region (rather than country) where park is
located. 3. Affected by success of studio entertainment and media networks divisions
Debt should be 1. Long-term 2. Mix of currencies, based
on tourist makeup at the park.
Consumer products
Projects are likely to be short- to medium-term and linked to the success of the movie division; most of Disney’s product offerings and licensing revenues are derived from their movie productions
Debt should be 1. Medium-term 2. Dollar debt
Interactive Projects are likely to be short-term, with high growth potential and significant risk. While cash flows will initially be primarily in US dollars, the mix of currencies will shift as the business ages.
Debt should be short-term, convertible US dollar debt.